Roxanne Bland is Tax Notes State’s contributing editor. Before joining Tax Analysts, Bland spent 17 years with the Multistate Tax Commission, where she worked with state revenue agency representatives to draft model legislation pertaining to sales and use taxation and corporate income, analyzed and reported on proposed federal legislative initiatives affecting state taxation, worked with legislative consultants and representatives from other state organizations on international issues affecting states, and assisted member state representatives in federal lobbying efforts. Before that, she was an attorney with the Federation of Tax Administrators for over seven years.
In this installment of The SALT Box, Bland examines underlying issues and implications in Synthes, particularly regarding the fairness of the Pennsylvania appeals process.
After reading the Pennsylvania Commonwealth Court’s opinion in Synthes USA HQ Inc. v. Commonwealth of Pennsylvania,1 several things struck me as odd. It was more than just the court’s reasoning, which I found dubious. Synthes raises issues that go far beyond the dispute between the Department of Revenue and the attorney general over the proper interpretation of the state’s sourcing statute for sales of services before the statute’s amendment in 2014, and it may have implications for the integrity of the department’s tax policies as well as the commonwealth appeals process.
The Synthes dispute centers around the proper interpretation of Pennsylvania’s statutory sourcing method for sales of services for years before 2014. Until then, the statute incorporated verbatim the language contained in the Uniform Division of Income for Tax Purposes Act, which dictates sales are to be sourced under the cost of performance or origination sourcing method where, if the taxpayer’s income-producing activity occurs within as well as without the state, sales are to be sourced where the greater of the income-producing activity occurred. In 2014 the legislature amended the statute to use the benefits-received or destination sourcing method, in which the sales are sourced to the customer’s location. The amendment was made applicable to tax years 2014 and thereafter. Significantly, the pre-2014 statute did not provide a definition of either “income-producing activity” or “cost of performance.”
For decades prior to the legislative change, the DOR applied the benefits-received method for sourcing sales in select circumstances. In the absence of a legislative definition of income-producing activity, the department defined the term as applicable where the customer received the benefit of the service; that is, the customer’s location. If the customer was located out of state, the sales were sourced outside Pennsylvania. If the customer received the benefit of the service both within and without the state – that is, if the costs for providing the service were incurred within and without the state, the cost of performance sourcing method was applied. The department’s interpretation that the statutory language supported the benefits-received sourcing method was not memorialized by regulation or other formal policy, but rather only through internal memoranda and other informal communications, including an “information notice” made available to the public. Support for the department’s interpretation was also not evidenced by any ruling from the department’s Board of Appeals, or the Board of Finance and Revenue, an independent tribunal housed in the state’s treasury department.
Synthes prepared its returns for the 2011 tax year under the cost of performance method. It later filed amended returns for that year using the benefits-received method, and according to its calculations, was due a refund. The refund claim was denied by the department because it determined that Synthes had not provided enough evidence to show where its sales occurred.2 The administrative forums upheld the agency’s decision, and the taxpayer appealed to the commonwealth court.
As in states such as Tennessee and Utah, in Pennsylvania the revenue agency is represented in court by the attorney general rather than by the agency’s attorneys. In direct conflict with the department’s interpretation of the sourcing statute, the attorney general asserted that Synthes was not due a refund because it correctly used the pre-2014 statutory cost of performance method to calculate its sales factor. The revenue agency intervened, asserting the taxpayer was correct to use the benefits-received method because that was the interpretation by the department. Deferring to the department’s interpretation of the pre-2014 statute, the court held for the taxpayer.
Questions. Lots of Questions
While it is not unreasonable that the department turned to Black’s Law Dictionary for help in interpreting cost of performance (a core statutory term left undefined by the legislature, and one that is crucial to interpreting the also-undefined term “income-producing activity”), what is puzzling is why, right or wrong, the department did not formally establish its interpretation with a regulation or other policy statement. The lack of memorialization is made even more puzzling since the department’s interpretation is one of decades-long standing. The court explained that it deferred to the department’s interpretation because having found the statute ambiguous, and both the department’s and the attorney general’s interpretations “facially reasonable,” “courts general defer to the expertise of the agency charged with interpretation and enforcement with respect to the statute. In this case, that agency is the department [and] deference applies unless the agency’s interpretation of its enabling statute is either erroneous or frustrates legislative intent.” All well and good, but should not that deference be contingent on a clearly enunciated policy that has been promulgated through a formal administrative procedure allowing stakeholders to be heard before it becomes a statement with the force of law?
That the department did not have a formal regulation on this issue takes on special significance considering the court’s statement that the department’s position was in existence “for decades.” According to a 2004 report issued by the department, it interpreted the statute to mandate the cost of performance sourcing method, which stated that “Pennsylvania assigns sales of particular services to the state in which the largest share of the costs were incurred to produce the service.” The report further recommended a legislative change to market-based sourcing.3 Did the court have this information prior to rendering its decision? If it had, would it have deferred uncritically to the department’s posture? One would hope not. The report also raises a disturbing question: Has the department changed its position before on the treatment of anything else that is taxable without notice?
As the dissenting opinion points out, the majority’s conclusion — the amendment of the sourcing rule for services from cost of performance to benefits-received merely clarifies the department’s long-standing position, which reflected the legislature’s intent — does not comport with precedent. The case relied on by the majority, Gilligan v. Pennsylvania Horseracing Commission,4 holds that a court may give strong weight to an agency’s interpretation of a statute if the subsequent amendment is without pertinent change. Yet that is not the case here. The dissent notes that the legislature left the cost of performance provision intact, and specifically added the benefits-received provision for services in a different section. Not only that, but the benefits-received provision language carves out from the cost of performance provision income covered by the new provision. The clear implication, the dissent says, is that the change in the statute evinces a change in legislative intent. Thus, the benefits-received position taken by the department prior to the 2014 amendment is incorrect.
Moreover, the majority’s conclusion that the department’s interpretation of the pre-2014 sourcing statute reflects the legislature’s intent is unsupported by the amendment’s legislative history. The fiscal note that accompanied the bill explained that the amendment would change the sourcing of receipts to the location where the customer gets the benefits, and the resulting revenue would “primarily be from out-of-state businesses with Pennsylvania-sourced service income.”5 Indeed, the then-secretary of revenue, Dan Meuser, testified before the House Finance Committee that the amendment implementing market-based sourcing would raise revenue for the state by subjecting out-of-state businesses to higher taxes.6 These points — the 2004 report and the amendment’s legislative history — were made to the court in the attorney general’s brief. Why did the court ignore them?
And More Questions
When I read the Synthes opinion, the primary question that jumped out at me was how the department and the attorney general, both vital instruments of state government, came to be in court battling over the interpretation of the sourcing statute. I spoke with Jennifer W. Karpchuk, an attorney with the Chamberlain Hrdlicka law firm in Pennsylvania, who kindly enlightened me about how the tax appeals system is structured in the state, and how the department and the attorney general work — or don’t work — together in their handling of tax cases. Once educated on the basics – that is, that the department represents itself at the administrative level, and at the court level, the attorney general represents the department – I turned to the question of how taxpayer settlements are handled. “At the commonwealth court, negotiations are with the attorney general’s office, with the department essentially acting as its client. The attorney general’s office reviews settlement offers with the department, and the department will indicate its acceptance or rejection of an offer to the attorney general. However, the attorney general will occasionally settle matters over the objection of the department,” Karpchuk said. There can be disagreements between the two in settlement negotiations “behind the scenes, which is when the attorney general’s office may occasionally settle a case over the objections of the department,” she added. This, Karpchuk explained, is because as the Synthes dissenting opinion pointed out, “the attorney general believes its role is to represent the interests of the commonwealth as a whole, and that includes its own conclusions on legal issues that could at times differ from those reached by the department.”
While Synthes may be the first time the benefits-received vs. cost of performance debate between the department and the attorney general has reached the court, it is impossible for me to believe this is the first time the issue has arisen during settlement negotiations. Indeed, Karpchuk cautioned me to not read too much into the court’s language suggesting “the department was unaware of the attorney general’s position prior to Synthes. Practitioners dealing with cost of performance issues over the years have been keenly aware of the disagreement between the department and the attorney general’s office regarding these cases.” Which, of course, leads me to wonder how benefits-received/cost of performance cases prior to Synthes came to be settled, especially now that the department and the attorney general’s disagreement has become public knowledge beyond the practitioner community. Over the years, surely this question has arisen more often than occasionally, when the attorney general may have settled a case over the department’s objections. If not, the department must indeed be a wizard of a negotiator if it can reach settlement agreements with taxpayers without their feeling the need to proceed further in the appeals process. If the department is not a settlement wizard, how did it and the attorney general reach an accord on the way such cases should be settled? Regardless of whether the department or the attorney general’s interpretation is right or wrong, could this mean that, over the years, similarly situated taxpayers were treated differently, depending upon which side “gave in” first? Or did the department and the attorney general simply flip a coin? Perhaps Synthes’s alternative argument underpinned by state’s constitutional uniformity clause should not have been dismissed so cavalierly by the court, but given the closer scrutiny it may deserve.
Conclusion
In my view Synthes is more than simply a clash between tax titans. The matter of whether the interpretation of the department or the attorney general concerning the pre-2014 sourcing statute is correct is important, but there is more to consider. Synthes carries with it several deeper implications that go far beyond the department and attorney general’s bare disagreement. Indeed, it may not be a reach to say that the underlying questions Synthes has brought to light goes to the heart of the fairness of the commonwealth appeals process. The attorney general has filed exceptions to the commonwealth court’s opinion, and it will be interesting to see what the court has to say after re-argument.
FOOTNOTES
1 No. 108 F.R. 2016 (Pa. Commw. Ct. July 24, 2020).
2 By the time this matter reached the court, the taxpayer and the revenue agency agreed that subsequent to the agency’s denial of a refund, the taxpayer had provided enough evidence to prove it was entitled to calculate its tax liability using the benefits-received method.
3 Pennsylvania Department of Revenue, “Pennsylvania Business Tax Reform Commission Report” (Nov. 30, 2004).
4 432 A.2d 275 (Pa. Commw. Ct. 1981).
5 Senate Appropriations Committee Fiscal Note to H.B. 465 (July 13, 2013).
6 Testimony of Dan Meuser, secretary of the Pennsylvania Department of Revenue, before the House Finance Committee, Apr. 11, 2013.
END FOOTNOTES